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Money, Finance and Monetary Policy


... Finance and Monetary Policy. Sawyer: The UK Economy 16e. Money and finance: ... of resources and, in particular, resources which often finance new investment. ... – PowerPoint PPT presentation

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Title: Money, Finance and Monetary Policy

Chapter 6
Sawyer The UK Economy 16e
  • Money, Finance and Monetary Policy

Money and finance The Financial System
  • A financial system is composed of firms and
    markets which fulfil a variety of economic
  • Central to all is arranging the lending of funds
    from one economic agent to another.
  • The financial system plays a key role in
    allocating economic resources.
  • Banks and other financial institutions determine
    the allocation of large amounts of resources and,
    in particular, resources which often finance new

Nature and Functions
  • Financial intermediaries are numerous and
    indirect finance is more common than direct
    finance. Advantages derive from the ability of
    financial intermediaries to use size and
    expertise to transform financial claims so that
    they can offer savers a wider choice of assets
    than ultimate borrowers are able to do.
  • They offer borrowers a more varied choice of
    credit terms than ultimate lenders are able to do.

Nature and Functions
  • Financial intermediaries also engage in risk
  • Retail banks provide for deposits to be
    transferred between accounts and thereby provide
    a payments mechanism.
  • Life assurance companies offer policies which
    provide for long-term saving but which also
    provide for a lump-sum payment in the event of
    the policy-holders early death.

The Bank of England
  • Acts as banker to the Government and keeps the
    main government accounts, receives tax revenues,
    and facilitates payments in respect of government
  • Acts as banker to the clearing banks, i.e. those
    retail banks which operate the system whereby
    cheques are cleared and monies transferred from
    one bank to another.
  • In May 1997 the Chancellor of the Exchequer
    granted a new autonomy to the Bank of England in
    the conduct of monetary policy. The prime
    objective of policy is to maintain inflation at a
    low level.

Inflation policy
  • The Government specifies a target for annual
    inflation and the Bank seeks to keep inflation
    close to the target level.
  • The inflation target is now set in terms of the
    measure of inflation used in the Euro zone, the
    harmonised index of consumer prices (HICP), with
    a target rate set at 2 per cent per annum.
  • Main instrument of policy is the level of
    short-term interest rates. If the Bank thinks
    that inflation is likely to rise significantly
    above target, it will raise short-term interest
    rates in the expectation that this will reduce
    the expansion of money and credit and hence will
    reduce the pressure of demand in the economy.

Private Banks
  • Retail banking involves the provision of a wide
    range of banking services to business and
    personal clients.
  • Services provided include taking deposits at
    sight and short notice, making loans of various
    types and for various time periods, cheque
    clearing, foreign exchange and international
    remittances, safe-deposit facilities and
    financial advice.

Private Banks
  • Investment banking involves a mixture of banking
    and security trading, and most offer a range of
    specialised financial services to large and
    medium-sized companies and affluent persons.
  • Investment banks also manage new issues of
    securities by companies and also buy and sell
    existing securities on behalf of clients.

Measures of Money
  • Money serves first and foremost as a medium of
    exchange i.e. it facilitates the exchange of
    goods and services.
  • Money also serves as a store of value.
  • Money may be an imperfect store of value and most
    monies depreciate over time due to inflation, but
    for many purposes it remains a convenient means
    of storing value.
  • Money also serves as a unit of account it is the
    means by which we measure value.

Measures of Money
  • There can be no unambiguous statistical
    definition of what constitutes money.
  • The Bank of England has, since 1993, focused
    mainly on two measures
  • The narrowest definition, M0, covers notes and
    coin in circulation plus banks operational
    balances at the Bank of England.
  • M4 comprises holdings by private-sector residents
    of notes and coin and all sterling deposits
    (including CDs) at banks and building societies.

Short-Term Money Markets
  • The main markets for short-term funds are the
    interbank market, the market in large time
    deposits from non-bank sources, the market in
    CDs, and the market in repurchase agreements or
  • There are also markets in short-term paper, i.e.
    negotiable instruments maturing within a few
    months. These include Treasury bills (issued by
    the UK government), commercial bills (issued by
    companies to finance trade, frequently with a
    bank guarantee), and commercial paper (issued by
    companies of prime-credit standing and without
    bank guarantee).

Short-Term Money Markets
  • Banks regard their short-term assets a source of
    liquidity but they can also regard their ability
    to borrow new funds at short notice as an
    additional means of liquidity.
  • The repo market has become one of the most
    important of the short-term markets in London and
    is now used by the Bank of England for the
    conduct of open-market operations. If the Bank
    wishes to take money out of the banking system it
    undertakes a repo, i.e. sells a security for
    immediate payment and agrees to repurchase at a
    later date. If the Bank wishes to put money into
    the banking system it undertakes a reverse repo.

Short-Term Interest Rates
  • The Bank of England has the ability to influence
    the level of short-term interest rates, and while
    that influence is felt first in the repo market,
    arbitrage will ensure it is immediately
    generalized across all short-term sterling
  • The Bank of England operates at the very short
    end of the lending spectrum - providing funds
    mostly for periods of about 14 days.
  • Longer term rates of interest are usually above
    short-term rates but by how much they are above
    depends on supply and demands for funds in the
    different markets.

The Capital Market
  • The capital market covers the markets in which
    securities - chiefly equity shares and bonds -
    are traded.
  • Equity shares represent a share in the ownership
    of a company and entitle shareholders to
    participate in company profits their value rises
    when profits rise and falls when profits fall.
    They are risky assets.
  • Bonds are generally fixed-interest, term
    securities and pay a fixed return each year until

The Capital Market
  • Equity shares can be issued in three main ways
  • A public offer involves a hitherto privately
    owned company deciding to go public, to raise
    money (for the company or for the existing
    owners) by selling shares to the public at large.
  • A private placement involves selling shares to a
    relatively small number of large investors and is
    cheaper than a public offer.
  • A rights issue is an issue by a public company of
    additional shares offered, in the first instance,
    to existing shareholders.
  • There are frequently periods of years when the
    level of share prices is rising (a bull market)
    or falling (a bear market). Chart shows the
    movements in recent years in the FTSE index of
    100 leading UK shares.

Markets in Financial Futures and Traded Options
  • Markets in financial futures and traded options
    have grown in number and in trading volumes in
    recent years.
  • Financial futures are financial assets such as a
    three-month bank deposit or a government bond
    which are traded today for delivery in the
  • They are one method of managing risk.
  • An alternative strategy is to sell bond futures.

Other Financial Intermediaries Life Assurance
Companies and Pension Funds
  • The essence of life assurance contracts is that
    the assured pays either a single premium or
    series of premiums over a number of years and at
    an agreed future date the insurance company
    guarantees to pay a lump sum.
  • Life assurance companies comprise a number of
    specialist companies as well as large general
    insurance companies that also offer marine, fire
    and accident insurance.
  • Pension funds provide pensions for members of a
    particular occupational group, or for employees
    of a particular company. Those covered by the
    fund make regular contributions over a number of
    years and, upon retirement, are entitled to a
    pension until death.

Other Financial Intermediaries Unit Trusts and
Investment Trusts
  • Unit trusts and investment trusts are the main
    forms of mutual investment in the United Kingdom.
    The purpose of mutual investment is to enable
    small investors to pool resources in order to
    gain the benefits of diversification.

Regulating the Financial System
  • During the last 25 years, there has been a series
    of Acts of Parliament to develop formal financial
    oversight and to create supervisory agencies.
  • The latest, the Financial Services and Markets
    Act of June 2000 provides statutory backing for a
    powerful new regulatory body, the Financial
    Services Authority (FSA).
  • The changes in British regulations have been
    influenced by negotiations in various
    international committees.
  • In the field of banking a key role has been
    played by the Basel committee, a committee of
    banking supervisors meeting regularly in Basel,
    Switzerland which has developed standards for
    minimum capital resources for banks.

Regulating the Financial System
  • It is an objective of the European Commission to
    achieve a single European financial market with
    financial institutions able to do business
    anywhere in the Community unhindered by
    artificial obstacles and constraints.

Regulating the Financial System
  • The Commission has pursued this aim with a
    three-pronged approach.
  • First, there should be that minimum harmonisation
    of regulations necessary to ensure fair
    competition and adequate consumer protection.
  • Second, institutions should not need
    authorisation to do business in each country
    once duly authorised by the competent authorities
    in one member country, they should be free to
    operate throughout the Community (the principle
    of the single passport).
  • Third, all activities of each institution should
    be supervised by the authorities of the country
    in which its chief office is situated (the
    principle of home country control).

Basel Committee and Capital Adequacy
  • The Basel committee seeks to devise rules which
    make banking safer and which are applicable in
    many countries. Initially the goal was to create
    standards which could be applied within the 12
    countries represented on the committee but
    nowadays there is extensive consultation and
    dialogue across the globe and the objective is to
    create standards that will be acceptable

Basel Committee and Capital Adequacy
  • The main effort in recent years has been has been
    to ensure that banks have adequate capital
  • The Basel committee has adopted the principle of
    risk-weighted capital requirements.
  • The minimum required capital (which once agreed
    upon is imposed on UK banks by the FSA) varies
    according to type of bank assets.
  • The risk weightings applied have been attacked as
    too crude a loan to a large well-known public
    company is assessed as being as risky as a loan
    to a back-street garage.